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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO DECEMBER 2014 NUMBER 329 Chicag Fed Letter o Understanding trends in state revenue sharing with local governments in Michigan by Martin Lavelle, business economist Over the past few years, discretionary cutbacks in state revenue sharing, as well as other related fiscal and economic factors, have led to budgetary challenges for local governments across the country, including those in Michigan. To study this issue in depth, the author looks at trends in revenue sharing between state and local governments in Michigan since the early 2000s. Note to our valued subscribers: Starting in January 2015, Chicago Fed Letter will be printed on an occasional basis with additional issues published more frequently online. To sign up for email alerts about new articles, download the latest issues, or search our archives, please visit www.chicagofed.org/ webpages/publications/ chicago_fed_letter/index.cfm. This Chicago Fed Letter examines the general role of state revenue sharing in local governments’ budgets by focusing on the case of Michigan. Many observers have asserted that a major contributor to the financial difficulties of local governments in Michigan has been the significant drop in revenue sharing funds from the state government. To study this assertion, I examine the roots of the fiscal problems facing Michigan’s local governments in recent years and the ways in which these governments have been dealing with diminished tax revenue bases. Michigan’s local governments began to experience fiscal stress about a decade ago, when the state economy started to perform poorly. More recently, the financial conditions of many local governments in Michigan continued to deteriorate even as the state government saw surpluses following the Great Recession. Consequently, multiple units of local government—including the City of Detroit, the Detroit Public Schools, and the City of Flint—have been under the authority of state-appointed emergency managers (EMs), who have the task of returning these public entities to fiscal solvency. If an EM determines that fiscal solvency cannot be regained through cost-cutting, the selling of assets, and negotiations with creditors, that EM can ask for state approval to take the public entity into bankruptcy proceedings, which is what happened with the City of Detroit.1 Current trends Revenue sharing programs can come under stress when economic activity slows, putting state budgets under pressure, which may in turn lead to decreases in revenue sharing with local governments.2 To a large extent, declining revenue sharing in Michigan has been due to the state’s weak economy. Michigan suffered a one-state recession, which began in late 2003 and lasted until mid-2009, when the nation’s Great Recession also concluded. During the one-state recession, Michigan experienced decreases in its own-source revenues and population, which ultimately resulted in declining state revenue sharing with local governments. As seen in figure 1, since 2002, local governments in Michigan have generally received fewer revenue sharing funds from the state with each passing year. The long decline in state funds available for revenue sharing with localities can best be understood by examining indicators of Michigan’s economy. The 2010 U.S. Census revealed that Michigan was 1. Michigan’s state revenue sharing with local governments 2. Michigan’s state revenue sharing as share of state spending millions of dollars 1,400 percent 70 1,200 60 1,000 50 800 40 600 30 400 20 200 10 0 2002 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 Statutory 0 1980 ’84 ’88 ’92 ’96 2000 ’04 ’08 ’12 Constitutional Note: The fiscal year 2015 value is a State of Michigan estimate. Sources: Fiscal years 2002–05 data from the Michigan House of Representatives, House Fiscal Agency, available at www.house.mi.gov/hfa/PDF/GeneralGovernment/ EVIP_Memo.pdf; and fiscal years 2006–15 data from the State of Michigan, available at www.michigan.gov/documents/ActualEstPayments_3018_7.pdf?20130801162626. the only state to lose population during the period 2000–10.3 The population loss was brought on by a sharply declining job base and a jump in unemployment. Meanwhile, Michigan’s residential real estate sector suffered a severe downturn. Michigan is not commonly identified with the mid-2000s housing price bubble. However, Michigan’s drop in housing market activity during that time was comparable to what happened in those places that were hardest hit by the housing crisis. Today, new home construction in Michigan remains around 67% below its long-term trend—twice the gap that exists between overall U.S. new home construction and its long-term trend.4 And with home prices having decreased sharply statewide over the 2006–12 period,5 taxable home values are down significantly. Amid all these difficulties, retail sales on an annual basis were lower in 2009–10 than in 2002–08, which meant that the state had fewer sales tax collections—the primary basis of the state’s revenue sharing program.6 As evident in figure 1, the state’s revenue sharing with local governments in Michigan is composed of two parts: a portion that is determined by the formula set forth in the state constitution and a portion that is based on the formula set by the state statutory program in place at the time. Since 2002, revenue sharing funds as mandated in the Note: This figure displays state revenue sharing with local governments as a percentage of state spending from only state revenue resources for fiscal years 1980–2013. Sources: Annual reports titled “Statement of the proportion of total state spending from state sources paid to units of local government (legal basis)” from the Library of Michigan. state constitution have been fairly flat, while such funds from the statutory program have fallen sharply. In Michigan, constitutionally mandated state revenue sharing with local governments began with the passage of an amendment to the state constitution in 1946;7 under article IX, section 10 of the Michigan Constitution, the state government must share sales tax revenue with local governments.8 In 1963, the amendment was modified to apportion 15% of the 4% statewide sales tax revenue to local governments on a per capita basis.9 A locality’s population count is determined by the U.S. Census Bureau and adjusted by subtracting 50% of the number of patients, wards, and convicts confined to public-tax-supported institutions within its borders.10 Although certain individual units of local government might have gotten fewer funds from the state under this formulation in recent years, the overall levels of constitutionally mandated state revenue sharing have stayed fairly consistent over the past 13 years. In contrast, there has been a clear trend in falling statutory revenue sharing. This pattern can be traced back to the early part of the last decade, when the State of Michigan started to face significant budgetary pressures. From then on, the state addressed its own fiscal problems partly through deep cuts to the existing statutory revenue sharing program. Over the period 1999–2010, statutory revenue sharing amounts were distributed according to a formula that was based generally on taxable home value per capita and population.11 Hence, those communities most adversely affected by economic travails (i.e., those that were already experiencing dramatic home value declines and population flight) tended to have their fiscal stress magnified by the erosion of state revenue sharing funds under this distribution formula. Shortly after Governor Rick Snyder took office in 2011, the Economic Vitality Incentive Program (EVIP) became Michigan’s statutory revenue sharing program. Local governments that received revenue sharing funds through the EVIP got significantly less than what they would have under the previous statutory revenue formula (e.g., in 2012 and 2013, local governments received a combined $173.5 million less than they would have).12 For fiscal year 2015, the City, Village, and Township Revenue Sharing (CVTRS) program has replaced the EVIP.13 Like the EVIP, the CVTRS program is likely to fall short of fully restoring statutory revenue sharing funds to levels before Michigan’s onestate recession (see figure 1). Given these policy changes, it is easy to see why state revenue sharing in Michigan local governments’ own-source revenueraising abilities. More B. Top five across United States A. Seventh District specifically, the deep Vermont 66.2 Michigan 43.3 drop in Michigan Arkansas 55.5 Wisconsin 39.6 home values greatly New Mexico 48.9 Indiana 36.7 stressed local budgets Delaware 47.1 Iowa 31.3 because local governMichigan 43.3 Illinois 28.5 U.S. 33.1 ments depend so highly on property Note: The U.S. value is the total dollar amount in state revenue sharing divided by the total dollar amount of local government budgets across all states. taxes to fund their Source: Author’s calculations based on data from the U.S. Census Bureau, 2011 Annual services. While local Survey of State & Local Government Finances, available at http://www2.census.gov/govs/ local/11slsstab1a.xls. own-source revenues declined (along with has fallen since the early 2000s. As shown revenue sharing funds from the state), local governments were hamstrung in in figure 2, state revenue sharing as a raising new revenues themselves from percentage of state spending from state resources fell to 56.3% in 2013 from its their own communities. The 1978 Headlee Amendment to the Michigan peak of 64.3% in 2002. Constitution explicitly forbids the use There is a wider context for understanding of some alternative revenue sources for the impact of Michigan’s declining state local governments in Michigan that revenue sharing with localities since the are employed in other states: Local early 2000s. In 1994, the state imposed governments are limited in their local a 2 percentage point increase in its sales income tax options; they may not institax (from 4% to 6%) to help fund a tute taxes such as sales or motor fuel much-expanded local school aid system taxes; and their use of the local prop(as mandated by Proposal A, which I erty tax is tightly constrained.18 The discuss in more detail later).14 And so, vast majority of states place some limifor most of the 1990s and early 2000s, tations on the local property tax, but local governments in Michigan became Michigan is among the very few with more dependent on state revenue sharing all four types of limitations (revenue, than those in most other states—and this levy, rate, and assessment limits).19 More relatively high state dependence remains specifically, local property and other in place today. As seen in panel A of local taxes may not be raised without figure 3, among communities of states local voter approval.20 If Michigan’s in the Seventh Federal Reserve District,15 property tax revenue base is broadened, local governments in Michigan are the property tax rates must decrease. If most reliant on state funding (with 43.3% property values (excluding those for of their budgets funded by the state); new construction and improvements) among all U.S. communities, Michigan increase at a rate greater than inflalocalities rank fifth in this regard (see tion, property tax rates must be adjustpanel B of figure 3). In fiscal year 2012, ed in order to maintain the same gross state revenue sharing with local governrevenue (changing strictly in line with ments represented almost three-fifths inflation alone).21 However, property (nearly $15 billion) of all state spending tax rates are allowed to drop at a rate from state resources.16 Figure 2 shows greater than the inflation rate.22 that the percentage of state resources dedicated to intergovernmental revenue A related feature currently putting additional fiscal stress on local governments sharing has fallen since the beginning is the manner in which Michigan schools of Michigan’s one-state recession, but are funded. Michigan schools’ operating has remained above its constitutional expenditures are funded primarily mandate (of 48.97%).17 through state tax revenues as a result Local fiscal ability of the passage of Proposal A in 1994.23 While this program shifts the responsiMichigan’s economic collapse during bility for funding education (equitably the past decade also directly impacted 3. Share of local government budgets from the state, 2010 across school districts) to the state, it also exposes local education funding to any budget difficulties the state may experience. After Michigan’s recession began in 2003, state revenue sharing to local school districts decreased. And despite Michigan’s economic rebound since mid2009, local school districts remain fiscally challenged, in part because of recent spikes in teacher retirement costs.24 Conclusion While economic downturns clearly put pressure on state and local governments alike, in Michigan’s case they have also added volatility and uncertainty into the revenue relationships between state and local governments. Because of changes to Michigan’s statutory revenue sharing program and tax code, local government officials have become increasingly uncertain that statutory revenue sharing will reach pre-2003 levels. Local governments in Michigan may be forced to adjust what their services programs can deliver because of expected lower amounts of state aid over the medium term and possibly the long term. Meanwhile, Michigan localities’ latitude to maintain their own programs with their own revenue sources is seemingly limited by law. Charles L. Evans, President Daniel G. Sullivan, ; Executive Vice President and Director of Research; Spencer Krane, Senior Vice President and Economic Advisor ; David Marshall, Senior Vice President, financial markets group Daniel Aaronson, Vice President, ; microeconomic policy research; Jonas D. M. Fisher, Vice President, macroeconomic policy research; Richard Heckinger,Vice President, markets team; Anna L. Paulson, Vice President, finance team; William A. Testa, Vice President, regional programs, and Economics Editor ; Helen O’D. Koshy and Han Y. Choi, Editors ; Rita Molloy and Julia Baker, Production Editors ; Sheila A. Mangler, Editorial Assistant. Chicago Fed Letter is published by the Economic Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. © 2014 Federal Reserve Bank of Chicago Chicago Fed Letter articles may be reproduced in whole or in part, provided the articles are not reproduced or distributed for commercial gain and provided the source is appropriately credited. Prior written permission must be obtained for any other reproduction, distribution, republication, or creation of derivative works of Chicago Fed Letter articles. To request permission, please contact Helen Koshy, senior editor, at 312-322-5830 or email Helen.Koshy@chi.frb.org. Chicago Fed Letter and other Bank publications are available at www.chicagofed.org. ISSN 0895-0164 For more details on Detroit’s bankruptcy filing, see www.chicagofed.org/ webpages/publications/chicago_fed_ letter/2013/november_316.cfm. Michigan’s statutory revenue sharing formula was frozen in FY2001 because of the recession back then. Over the period FY2001–10, local governments’ statutory revenue sharing payment was based on their 2000 receipt of statutory revenue sharing funds plus Michigan’s state budget; see 24th slide of www.crcmich. org/PUBLICAT/2010s/2012/EMU_ USRS_History_01-31-12.pdf. 1 Other research has found the tendency of state governments to cut local government aid during times of economic stress; see, e.g., http://publius.oxfordjournals.org/ content/early/2013/11/17/publius. pjt039.full (available by subscription). 2 See table 1 on p. 2 of www.census.gov/ prod/cen2010/briefs/c2010br-01.pdf. 3 Author’s calculations based on data from the U.S. Census Bureau. 4 Ibid. 5 See exhibit 3 on p. 8 of www.michigan.gov/ documents/treasury/ SalesUseTaxReport2012_432538_7.pdf. 6 See p. 9 of http://sites.udel.edu/ninadavid/ files/2013/09/POLICY-STUDIOCONSTITUTIONAL-REVENUESHARING-REPORT-FINAL-SEPT-2012.pdf. 7 See www.legislature.mi.gov/ (S(e04gak55sqo4h455o5bbamvb))/ mileg.aspx?page=getObject&objectName =mcl-Article-IX-10 . 8 Ibid. 9 See www.mi.gov/ treasury/0,1607,7-121-1751_2197-5658--,00. html. 10 For the fiscal year (FY) 1999 statutory revenue sharing formula, see www.michigan.gov/treasury/ 0,4679,7-121-1751_2197-5658--,00.html . 11 Author’s calculations based on data from www.michigan.gov/documents/ ActualEstPayments_3018_7. pdf?20130801162626. 12 See www.plantemoran.com/perspectives/ articles/2014/Pages/evip-update-and-tifreimbursement-reporting-deadline.aspx and www.michigan.gov/documents/ treasury/Detailed_Guidance_FY15_ CVT_468245_7.pdf. 13 Amendment has limited local revenue-raising powers, it does set state revenue and spending limits and prohibits the state from reducing its share of aid to local governments below a certain threshold or from shifting a tax burden to them; see www.mackinac.org/5574. Pew Charitable Trusts, 2012, “The local squeeze: Falling revenues and growing demand for services challenge cities, counties, and school districts,” report, Washington, DC, June; and www.lincolninst.edu/ subcenters/significant-features-propertytax/Report_State_Summaries.aspx. 19 See http://legislature.mi.gov/doc. aspx?mcl-Article-IX-31. 20 See p. 512 of http://ippsr.msu.edu/ publications/SOSSGrowth.pdf. Also, the Headlee Amendment states that property taxes cannot increase annually by more than 5% or the inflation rate, whichever is less; see www.mml.org/resources/publications/ one_pagers/opp_headlee_override.pdf. 21 See www.chicagofed.org/digital_assets/ publications/chicago_fed_letter/2004/ cfljune2004_203.pdf. 22 The Seventh District comprises all of Iowa and most of Illinois, Indiana, Michigan, and Wisconsin. 23 14 15 See www.crcmich.org/ PUBLICAT/2010s/2012/sbn2012-03.html. 16 See note 5 on last page of www.michigan.gov/ documents/fy01_sec_30_report_34917_7.pdf. 17 See http://crcmich.org/TaxOutline/ index.html and www.michigantownships.org/ revenue_sources.asp. While the Headlee 18 See www.clinton-county.org/Departments/ Equalization/ProposalATaxableValue DecliningRealEstate.aspx. For further details on Proposal A, see www.michigan.gov/documents/ propa_3172_7.pdf. See www.freep.com/article/20140203/ NEWS06/302030053/ Snyder-education-funding-increaseMichigan. 24